A Downturn We Don't Deserve. Market Morality Plays Make for Bad Policy

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We deserve this. Or so many of us think watching the stock market plunge. Somehow, humans view the Dow Jones industrial average as a morality play. A period of high times, we reason, must be followed by a commensurate dark period. That questionable lending in the subprime mortgage sector sparked the turmoil seems to confirm this rule.

There is, of course, no such law. Sure, lenders preyed on naive home buyers. And sure, downturns follow recoveries. But bad times do not have to match the good in intensity. What turns a mortgage problem into a recession, or a Depression, is an accumulation of policy errors — by political leaders, central banks or foreign governments. And moralizing tends to distract from the policy challenges.

Consider the Great Depression, which, we were taught, was the ultimate morality play. The 1920s markets were bubbly madness. Little true growth underlay the price increases. Then came 1929. The decade of splurge required a decade of penance.

This cuts out a lot of reality. While the stock market of the late ‘20s was probably too high, it was not high enough to cause “The Grapes of Wrath.” A few years ago, Edward Prescott, a Nobel Prize winner, and Ellen McGrattan looked at the Dow in a paper for the Minneapolis Fed. Stock prices relative to fundamental values of corporations were underrated, even in August 1929, they concluded.

The crash turned into a depression because of erroneous policy, separate missteps here and abroad. One was the Versailles Treaty: Statesmen forced Germany to pay impossibly heavy reparations after World War I. This unbalanced the international monetary system and eventually helped cause a deflation here, which hurt banks, which made the market’s crash hard to bounce back from.

Herbert Hoover made his own missteps. He raised taxes in a downturn. He mistook the deflation for inflation. He ordered businesses not to lay off people, which they needed to do to survive. He signed a ridiculous tariff, Smoot-Hawley, even though more than a thousand economists begged him not to. Worse, Hoover took the stock market to task, berating short sellers.

Franklin Roosevelt issued his famous call for confidence, “We have nothing to fear but fear itself,” but he, too, made policy errors. In his first inaugural address he presented the downturn as a spiritual collapse: “Practices of the unscrupulous money changers stand indicted in the court of public opinion,” he announced. Only by rejecting materialism could the country recover, he added. “The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.”

Several of the laws enacted in those first Hundred Days were damagingly moralistic and wrongheaded. Under the codes of the National Recovery Administration, for example, a family of chicken dealers was not permitted to lower prices on the theory that low prices were hindering recovery. They were indicted for allowing customers to choose which chicken they bought — on the weird theory that consumer choice impeded efficiency, which in turn impeded recovery.

The Roosevelt administration also prosecuted two great financial figures: Andrew Mellon, who as Treasury secretary had served Harding, Coolidge and Hoover, and Samuel Insull, the utilities innovator who electrified Chicago. Today’s equivalents would be prosecuting Alan Greenspan and Steve Jobs — a chilling thought.

There’s plenty of good market news this summer. Industrial production, a vital sign for the U.S. economy, is up. Businesses are profitable. Federal Reserve Chairman Ben Bernanke made a career studying the consequences of deflation and bank failures in the 1930s. That’s why he knew to infuse money into the system last week. He’s more likely than many to spot a need to supply extra dollars to the economy. The feared scenario is of the subprime market trouble widening across sectors, sparking a crisis similar in magnitude to the savings and loan collapse. That crisis seemed bad at the time, but in the history of American growth, it is a blip.

Is a serious downturn possible? Yes, especially if Washington makes bigger mistakes. If Democrats win the White House by turning against free trade and then pass protectionist laws, they will be pulling a Hoover. China will trade elsewhere. Taxation is another concern. Many lawmakers want to increase taxes to cover Social Security and Medicare shortfalls. Lifting the Social Security cap, so that every dollar of income for higher earners is subject to the payroll tax, seems an easy remedy. Democrats want the Bush income tax cuts to expire. When John Edwards advocated this last month, his words could have been taken out of a Hoover or Roosevelt speech: “it’s time for us to put our economy back in line with our values.” In reality, a combined change in these two levies would be a terrible blow to U.S. competitiveness, a sort of Sarbanes-Oxley of taxation. If China could no longer see a difference between the United States and Europe, it would move more cash into euros. King Dollar might lose its throne.

In other words, the great U.S. downturn that everyone fears is possible — if lawmakers get carried away with their own sanctimony. Not because we deserve it.

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